We finally had a few things to concentrate on in September.
From a market perspective, what was interesting was the beginning of the pricing-in of inflation and the expected tapering of extraordinary monetary support from the US Federal Reserve. Whilst last month’s announcement was a damp squib, further commentary from Regional Presidents seemed to convince the market that longer term (10-year) yields needed to be higher, and we saw the Australian government 10-year yield follow the US Treasury about 30bps (0.30%) higher over the month.
This is despite Australia’s ongoing lockdowns and concurrent pressure on the economy, as well as the fact that in 80% of cases where the Fed removes policy stimulus it results in recession (and lower long-term yields).
We also saw more primary issuance that was of interest to us when QANTAS (QAN) opportunistically tapped the market for a 7-year bond to fill out their curve. More on this below.
Conservative portfolio:
This portfolio is all investment grade and all AUD.
The current portfolio yields 3.09% and consists of 10 bonds of roughly equal weight by value to total an approximate $500k spend.
The rise in yields allied to our rebalancing of the longer fixed rate portion of the portfolio pushed the yield back over the magic 3.00% level. This looks a good time to take advantage and lock away these higher yields.
The QAN 7-year bond, mentioned above, came with the expected new issue premium and looked about 20bps cheap compared to the secondary market. The effect of this was to reprice the existing bonds wider. Along with the rise in base rates, this made the 2030 maturity look very attractive with a yield nearly at 3.50% and so we therefore switched out the Transurban 2031 bond for this one, improving the yield by nearly 0.50% from last month.
We also finally found some significant supply in the NAB 4.95% fixed rate 2029c AT1 hybrid. An initial $500k was snapped up in minutes in June when we first uncovered this bond, and we had been looking for it ever since.
In this low yield environment, moving down the capital structure in large, highly rated issuers is the best way of enhancing yield whilst minimising risk – see here for our article discussing this opportunity.
We therefore switched out the LendLease 2031 bond, maintaining the same investment grade credit rating and improving the yield by nearly 1.00%.
Both of these trades reduced tenor (albeit introducing extension risk in the NAB bond, noting that a major bank has never failed to call a hybrid, so we see this risk as very low) and improved yield whilst maintaining credit rating – the trifecta of attributes one looks for when evaluating switches.
Balanced portfolio:
The Balanced portfolio adds higher yielding bonds to the base Conservative portfolio to achieve a higher yield, while still maintaining a balance between risk and return, skewed towards preserving capital rather than chasing yield.
It aims to have between 15-20 positions, with the high yielding bonds in smaller parcel sizes (comprising 27% of the total portfolio) to reflect their riskier nature.
The current portfolio has 15 bonds, yields 3.85% and is an approximate $670k spend.
Nothing again to add this month apart from the same switches as in the Conservative portfolio, which added 0.30% to the portfolio yield as the high yield bonds held their yields better than their investment grade comrades. Better economic prospects (i.e. higher government rates) are typically better for high yield bonds as their risk of default decreases, plus with their higher coupons they are less affected by rising base interest rates.
High Yield portfolio:
The High Yield portfolio looks to generate a high yield while still looking to have a bias towards as low risk positions as possible.
This is achieved by good diversification and attempting to identify fundamentally mispriced bonds.
The current portfolio has 16 bonds, yields 5.51% and is an approximate $500k spend, demonstrating the concept of greater diversity in higher risk positions.
We reintroduced a bond to the portfolio this month – Lucas 9% 2022 (“Lucas”). Lucas has had a challenging COVID-19 period and investors agreed to waive some terms of the bond to allow them to trade through, like many other high yield issuers.
This support from investors has paid dividends, with new contracts and operating performance returning to pre-COVID-19 levels, and pleasingly performance has also returned.
As the bond price has reflected this recovery, we return the Lucas bond to the portfolio as it represents a lesser risk than it did when the future was more uncertain. With a short maturity in September 2022 and amortisation payments resumed, the exposure in this bond continues to derisk and it offers a high yield of nearly 8.00% after the coupon uplift as part of the compensation for the waivers given in mid-2020.
As mentioned above, conditions have been good for high yield in September, and as such yields moved slightly lower. The reintroduction of Lucas at a high yield has more than balanced this out, with the portfolio yield increasing by 9bps over the month.
Other USD bonds we like:
The table below continues to show other USD bonds we like that don’t fit the parameters of this particular portfolio.
We are hopeful of some good news in the next few weeks about being able to offer these larger minimum parcel bonds in smaller parcel sizes to make the more accessible to investors. If this is confirmed, we will include our top picks in the portfolios from next month.
All are subordinated in the capital structure which is one of the best ways to generate yield in this environment – you can find our article on the subject here.
